April 2013

Clearing regulations could create revenue opportunities for lenders, such as fund managers, through collateral rules. Nicholas Pratt considers the right approach to the market, but finds the opportunity may be limited.

Changing regulations in the over-the-counter (OTC) derivatives markets mean asset managers could find “serious money” to be made from their low-yielding but high-quality government securities.

A shortage of high-quality government bonds is predicted when regulations come into force that require high-quality collateral to be posted with central counterparties in order to clear OTC derivatives.

For any asset managers with these types of assets – which are known as specials – then collateral transformation means they could find new borrowers in the securities lending market.

“There are some big numbers forecasted. Should these levels of demand materialise, it could become a once-in-a-lifetime opportunity for beneficial owners holding these types of assets to make some serious money,” says Saheed Awan, global head of collateral services at Euroclear.

The level of awareness among asset managers of this potential windfall is unclear. Custodian bank lending desks, which run lending programmes, are likely to be the first option for asset managers. But asset managers should not confine themselves to a single option, says Awan.

They should consider all routes into the lending market: building their own lending desk; working through a third-party; or through an electronic lending network.

“For general collateral, where the volumes are high and the margins are low, it is best to use an automated, electronic platform,” says Awan. “Or if the asset managers are big enough, they could do it themselves.”

Collateral transformation may be a once-in-a-lifetime opportunity for high-quality assets like government bonds to be lent out, but it is still unclear exactly how strong the appetite will be among not just borrowers and lenders, but also the intermediaries who have to broker the deals, says David Little, head of securities finance at Calypso.

“Someone has to get those assets from the beneficial owners to the borrowers and, if they have to sit on the intermediary’s balance sheet, that will create some constraints,” he says.

For asset managers, whether they are a potential borrower because of their derivatives activity, or a potential lender because of the quantity of general collateral they hold, it is important to examine the assets within their portfolios and assess their value as collateral, says Little.

“The buy-side firms need to have a good and independent view of what’s happening. They want verification of all data, preferably from independent sources that keep track of their portfolio and assets. They need both systems and service support – a transformation of current business processes.”

There are also some who believe collateral transformation is not the next big thing but just a new name for a familiar practice. “It is just another type of repo trade,” says Jamie Lake, principal consultant at GreySpark Partners.

It also remains to be seen how much of a market there will be given the size and depth that would be needed, he says. “It may be reminiscent of the millennium bug where there is a tense build up to the event where everybody fears the worst, and then the event passes almost without notice.”

The fact that the collateral transformation market has grown as a result of the introduction of central clearing in the OTC derivatives world is an irony of sorts. “From the regulatory perspective, the central clearing model may look respectable and transparent but, underneath, there is the potential to develop a collateral transformation market that will have far less visibility,” says Lake.

INDEMNIFICATION“Some of these transactions are being done as swaps, so going through central clearing but, underneath, people are swapping out the lower quality collateral on the repo market as long-dated repo transactions.”

For the beneficial owners holding high-quality collateral, the opportunity to make money through collateral transformation must be weighed against the risk of default from borrowers, says Lake. “You may get a return but the flipside is that you might find it hard to get those assets back, so the risk appetite has to be there.

“There is also the question of expertise. If that is not your area of expertise, you should not be engaging in it. There is a protection and an indemnification that comes from having a third party doing some of this.”

The fears of a collateral shortfall may be somewhat exaggerated, according to some people who believe that the kind of numbers quoted (anywhere between $2 trillion [€1.5 trillion] to $15 trillion) are because of some overzealous extrapolations that do not take into account the amount of trades already collateralised or the possibility that there will be a reduced amount of participants in the derivatives market once central clearing becomes mandated on a more widespread basis.

There is also the possibility that central counterparty clearing will become more open to receiving a wider range of collateral as competition becomes more pronounced. Additionally, there is a substantial amount of high-quality securities (or general collateral) not being lent at present, as figures from the likes of Markit (formerly Data Explorers) show.

THREE STEPSConsequently, there are some in the market, such as Paul Wilson, global head of client management and sales for agency lending at JP Morgan, that anticipate a less frenetic increase in securities lending as a result of collateral transformation needs. “Over time, there will be an increased demand for high-quality collateral but it will be something that is phased in rather than something that arrives in one big impact.”

A further check on the growth of the collateral transformation market has come from the regulators, notably the recent guidance issued by the European Securities and Markets Authority.

Any collateral received by Ucits funds via efficient portfolio management techniques, such as securities lending or repo, will not be eligible to meet clearing and margin obligations for OTC derivatives transactions under the European Market Infrastructure Requirements Directive. The concern is that this type of collateral will be used to build excessive leverage.

For investors considering entering the securities lending market for the first time as a result of the revenue-making potential generated by the collateral transformation market, Wilson believes there are three steps that should be taken.

The first is to understand how the regulations will impact them in terms of their changing collateral requirements across all trade types and fund ranges. Second, investors need to understand how they can get to the position where they can transact as usual with the appropriate margins and collateral. And the final step is to be able to optimise their collateral needs and undergo any collateral transformation. “It is difficult to get to step three without having gone through the other stages first.”

Wilson adds: “Collateral is almost becoming a new asset class and investors need to operate on platforms that help them to solve the collateral conundrum.”

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